Feb 15, 2011

There are five rules for simplifying your way to financial success. They work for everyone, all the time. If you resolve to follow them, you may not get rich in 2011, but you'll certainly be positioning yourself to get rich in the future.

1. Speed up your savings.

The fastest way to riches is to save more money now. It's far more effective than chasing higher investment returns. For example, say that you're putting away $500 a month and raise it to $600. That's a 20 percent gain in your retirement account. Where else can you get a guaranteed increase like that today?If you're living paycheck-to-paycheck, you probably think that you can't save another dime, but you can. Arrange to have the extra money taken out of your paycheck automatically -- either through payroll deduction or by using your online bank account to have money moved into your savings account every time a paycheck comes in. You'll discover, to your surprise, that your lifestyle won't change. You'll simply adjust your spending -- a little here, a little there -- to make up for the money that's no longer in your checking account. It's the only known magic in the world of personal finance.Some people living paycheck-to-paycheck are earning $250,000+ a year (remember the "I'm-not-rich" outcry when they thought that their taxes might go up?). The higher you live on the hog, the sorrier you'll be if you hit retirement without enough money to keep your gold-plated lifestyle going.

2. Use the tax code to ramp up the size of your retirement account.

I'm constantly running into employees who save enough to get the company match of 3 or 5 percent of pay, and then quit. Why would you do that? Better to pack your automatic savings into a tax-deferred retirement plan. Tell your company to take more out of your pay, or sign up for automatic annual increases if they're available. Some companies offer Roth retirement plans -- you don't get a tax deduction for your contribution, but the earnings accumulate tax-free. That's a deal I'd take.If your company doesn't offer a retirement plan, create your own. Pick a low-cost mutual fund group and ask about its Individual Retirement Accounts. The self-employed should consider solo 401(k)s or SEP-IRAs.

3. Switch to index investing.

Give up the illusion that you're smart enough to beat the professionals whose trading sets the market's price. They love you to think that way because they charge you high fees to try -- wrap fees, insurance fees, annuity fees, marketing fees, brokerage fees, account fees, etc. You can't help but underperform, after all those costs. Tons of research shows that mutual fund managers don't beat the market either, over time. They might ride some hot stocks for three or five years, which is when they'll roll out the advertising and get you to invest. Then those hot stocks cool and they fall behind. You'll be paying your manager to miss. How does Wall Street get away with it? Because most do-it-yourself investors have no idea how well their stock-picking or fund-picking performs. You remember your winners, forget your losers, neglect to average the two of them together, and so have no idea how well your results compare with general market returns.Odds are, you've done worse -- much worse. You'd be richer if you had dumped the lot into index funds. So give it up. Switch to index funds that follow the markets as a whole. Vanguard has the largest variety of super low-cost funds. You'll also find good index funds at Charles Schwab, Fidelity, and T.Rowe Price.

4. Divide your money between stocks and bonds in a way that's appropriate for your age.

Stocks should be included at any age. The cautious investors who stampeded into bonds after the 2008 market meltdown missed this year's 9 percent gain in the Standard & Poor's 500-stock average, and the 76 percent gain since March, 2009.One useful diversification rule is to subtract your age from 110. The number that results suggests how much of your total, long-term investments you could reasonably allocate to stock funds. So for example, say you're 60. Subtracting that number from 110 gives you 50. You might put as much as 50 percent of your money into U.S. and foreign stocks and 50 percent into bonds. At age 40, you'd put 70 percent in stocks and 30 percent in bonds.Alternatively, invest in a target-date retirement fund, where the asset allocation will be done for you. At Vanguard, you can get target-date and index funds in a single package.

5. Rebalance your investments.

It's important to maintain your chosen division of stock and bonds. For example, say that your target is 60 percent stocks and 40 percent bonds. If the market rises by so much that you're now 65 percent in stocks, sell some of those shares to bring the percentage back to 60 percent and invest the proceeds in bonds. If the market drops so that stocks now make up only 55 percent of your portfolio, sell some of your bond shares and reinvest the proceeds in stocks.

Emotionally, rebalancing is hard because you're going against the herd. But financially, it's a winner. You're always selling high, buying low, and managing your risk. Don't bother rebalancing on small dips, though. Do it only if your target percentages fall 5 percentage points out of line.

It's impossible to rebalance intelligently if you own individual stocks and difficult with managed mutual funds, since it's never clear which ones you should sell or buy. So here's another advantage of working with index funds -- they make rebalancing simple. And target-date funds are rebalanced for you automatically.

Using this five-point program, you can forget about fickle individual stocks, complicated annuities that carry high (and sometimes hidden) fees, wrap accounts, and all the other offerings that will make only your broker rich. KISSes to all, in 2011.